DFS Lab BlogOur latest thoughts on all things fintech

For the 2.5 billion people who live on less than $2 per day, shocks such as illness, crop failures, livestock deaths, farming-equipment breakdowns and even wedding or funeral expenses can be enough to tip them, their families, or even an entire community below the poverty line. A major challenge for international development efforts is determining which financial tools provide durable buffers against such setbacks.

While meeting this challenge is a clear priority for policy makers and donors, it is also a major profit opportunity for commercial players who can solve market failures and create real value. Personal savings, insurance, credit, cash transfers from family and friends and other financing mechanisms offer promising opportunities to create security and steady employment but they require a nuanced understanding of product design and the local market conditions in order to be effective.

We recently conducted a literature review of rigorous academic studies of financial service innovations among the very poor to find out what services and products would unlock the most value for those at the bottom of the pyramid. Our findings are captured in a working paper which we summarize below.

Traditional microcredit hasn’t lived up to expectations, but we are learning how to improve it. The Grameen model of microfinance gained a great deal of attention in the international development field after early data showed that it was associated with high repayment and low default. This model makes small loans, usually to women, without requiring collateral. However, seven randomized evaluations from around the world show that this type of ”one size fits all” microcredit product did not increase the average incomes or consumption of households. Expanded access to microloans did lead some entrepreneurs to increase business investments, but rarely to increased profits. Only one study found that microloans increased women’s decision-making power.

Savings accounts are effective safety nets—especially if they apply insights from behavioral sciences. People don’t need to borrow money during a personal crisis if they have their own savings.One study showed that just eliminating the costs associated with opening a savings account in Kenya significantly increased uptake, overall savings, and investment levels among market vendors. However, while replication studies in Uganda, Malawi, and Chile also found that removing account opening costs increased savings, this was partially offset by a reduction in informal savings and there were no observed impacts on business investment or income. In Nepal, offering female-headed households a no-fee basic account with deposit collection service (i.e., tellers came to their home) led to high uptake and usage and real improvements in welfare. Households responded better to health shocks and spent 20 percent more on education and 15 percent more on meat and fish.

Often, the beneficial impacts of savings accounts can be enhanced by features that help people overcome behavioral biases by, for instance, fortifying willpower. So-called “commitment savings” products have lock-up periods, fees, or other penalties for early withdrawal that “commit” the client to a savings goal. These types of features increased decision-making power for women in the Philippines, with even larger effects for women who started out with below-median decision-making power. In Kenya, a simple “Safe Box” that allowed users to save for preventive or emergency health in a metal box to which they had a key increased achievement of health savings goals by 14 percentage points.

Insurance is highly valuable to protect against shocks but is difficult to scale. In Ghana, farmers who received rainfall index insurance cultivated more land and spent 13 percent more on fertilizer and labor than those who received just cash, implying that uninsured risk — not lack of access to capital — is a primary constraint on investment by farmers. In India, when farmers were given rainfall index insurance, six percent more farmers focused production towards higher-return, higher-risk cash crops.However, despite the potential of insurance products to provide a “risk floor” for farmers and encourage higher-productivity investments and behavior, uptake at market prices is extremely low and commercial offerings have not found a profitable delivery model. Micro-insurance is not at scale anywhere except when heavily subsidized by government, a market we hope technology may change in the future.

Digital financial services let people help each other. Digital payments—for instance, by mobile phone or app—can significantly strengthen people’s financial resilience by enabling an informal risk-sharing network through loans or gifts from friends and relatives. In Kenya, users of mobile-based money-transfer service M-PESA maintained their consumption and spending in the face of economic shocks; non-users of M-PESA had to reduce consumption by 7 percent when facing these shocks. During these hard times, users were more likely to receive domestic remittances—more money from a larger number of people. These improvements in risk-sharing led to higher savings, higher consumption and changes in occupation for user households.

Digital platforms have the potential to change financial services in three ways. First, they may reduce financial institutions’ costs. Second, they can increase the reach of financial products, as traditional brick and mortar channels make it difficult to deliver financial products to people in remote areas. And third, digital platforms can facilitate innovation in product and service design. For example, digital platforms can be configured to improve the customer experience by offering sub-accounts or labeling accounts, and they can provide bank managers with real-time information and other decision aids that can help banks provide better service to clients. Yet there are potential downsides for the bank and the client, since digital products are accessed and disbursed digitally without any face-to-face interaction. Financial institutions must adjust how they analyze client risk, collect payments, optimally cross-sell products without getting to know customers in person. Lack of customer contact could drive up default rates, if not dealt with properly. Ultimately, digital finance may alter client behavior dramatically—for better or worse—with instant access to financial products and information, new user interfaces, and other accompanying changes. Researchers are now studying how digital financial products should be optimally designed to address these potential risks.

We believe that understanding the underlying market failures is the key to designing effective financial products and interventions. Economic theory suggests that we only fully tap the potential of financial markets when information flows freely and symmetrically, when participants choose rationally, when property rights are enforceable, and when transaction costs and barriers to entry are low. In developing economies, market failures and distortions are so strong that all five conditions often fail at once. For instance, lack of information about credit-worthiness—as well as lack of consistent screening ability among lenders—hinders the efficacy of loan programs; traditional bank accounts often are not profitable without high transaction costs that can deter poor borrowers such as long wait times, poor service, high withdrawal fees and high required minimum balances; women often do not have control over their own property; many rural markets are served by monopoly providers, and so on.

Understanding the roots of these market failures—and the evidence on the efficacy of existing financing interventions— will allow the next generation of financial services to better serve the world’s poor. To do so, donors, governments, and private sector players will have to answer some challenging questions: Can we find new technology-based models for digital credit that will succeed where microcredit has failed? Is there a viable way to scale insurance for small farmers? How can we encourage the delivery of well-designed saving products? Can financial products be used to empower women consumers and entrepreneurs?​With the advent of fintech, there is now an active community of scholars, donors, practitioners and technologists working together to find answers to these questions. With continued effort and innovation, we can continue to develop the right financial tools to support the world’s poorest households in resisting shocks and seizing opportunities to climb out of poverty.

Originally published in the Harvard Business Review on October 5, 2016. See the original article here.